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Practice questions for final exam
Warning: This list of questions by no means is comprehensive. You can
get questions from concepts outside this list.
1. What creates long run growth in full employment GDP, GDP/capita (income per
person)?
Answer:
Y
 y  f k 
L
k  sf  k    d  n  g 
Increases in saving (or investment), population growth, and technological changes will
cause Y to grow while only technological change will create permanent growth in
GDP/capita. Note, however, that increase in the savings rate 's' will create temporary
growth in GDP/capita until you reach the new steady state capital stock level.
2. What can the government do to promote growth in GDP/capita (both temporary and
permanent)?
Answer:
The government can encourage technological innovations for permanent growth. Ways to
encourage research and development is by using government organizations to fund
research projects. Organizations involved in such activities are National Science
Foundation and National Institute of Health, etc. The government also uses patents to
reward innovative behavior. By providing patents to inventions, the government rewards
the inventor with temporary monopoly power, which leads to higher profits.
Increasing savings rate in the nation can also create temporary growth in GDP/capita.
This will lead to income per person to grow from $25,000 to $30,000, for instance. Once
it reaches this level (which is the new steady state), the growth in income per person will
stop. Increases in the savings rates can be achieved directly by increasing the budget
surplus (public saving) or encouraging increases in private savings through programs like
IRA's and 401k.
3. Explain determinants of inflation according Philips curve.
Answer:
Philips indicates that more than one variable is responsible for inflation: inflation
expectations, deviations of output over full employment output level and adverse supply
shocks.
   e  a Y  Y f   z
Philips Curve:
(yf is full employment output growth,  is inflation, and z is supply shock).
4. What effect does government policies have when agents are rational?
Answer:
Rational agents learn from what they have observed in the past. Therefore, if the
government applies a policy the agents have previously seen, they will adjust their price
expectations accordingly. This aggregate supply will offset the effect of government
policies on the output level and exacerbate the effect on prices.
5. Explain the pros and cons for money rules and discretionary policy.
Answer:
Money rules prevent unnecessary reaction from the workers, stabilizing their price
expectations. However, it takes away the flexibility away from the government to react
to unexpected shocks. Proponents of this type of monetary policy assume that the
economy, if left on its own, will move smoothly along the long run trend of growth in full
employment output. Discretionary policy enables the government to smooth short run
business cycle fluctuations around the long run trend, however, may result in stagflation
due to unnecessary adjustments in workers' price expectations.
6. Explain how aggregate demand and aggregate supply are generated in a national
economy.
Answer:
Aggregate demand will be determined by the combination of the money and goods
markets. Level of demand in an economy is going to be the sum of demand of households
(consumption), demand of businesses (investment), demand of government (government
expenditure), and demand of foreigners (net exports). Money market will indirectly affect
demand level by determining the interest rates, which in turn sets the investment level.
Aggregate supply is determined (in the short run) by the combination of the labor market
and the production function. The labor market (labor supply and labor demand)
determines the quantity of employment, the only variable input in the short run. The
production function shows the supply of output that can be obtained from the use of this
input.
7. Why is medium run aggregate supply positively sloped?
Answer:
Workers do not realize that prices are changing. Therefore, only firms will respond to
price changes, causing employment as well as output to increase with higher prices (until
change in P is realized by workers).
8. What causes the IS curve to shift? What causes the LM curve to shift? What
results in movement along each curve?
Answer:
Any exogenous change in the goods market will shift the IS, changes in income
and interest rate will cause movements along it. Any exogenous change in the
money market plus changes in price will shift the LM, changes in income and
interest rate will cause movements along it.
9. Graphically depict an IS-LM model that represents monetary policy
ineffectiveness. Fiscal policy ineffectiveness. Explain the difference.
Answer:
For graphical answers, look at your notes. Monetary policy works through
interest rates. When the Fed cannot change interest rates effectively (high
interest elasticity of money demand or flat LM) or when this change in rates
does not stimulate investment (low interest elasticity of investment or steep IS),
monetary policy does not work so fiscal is better. Fiscal policy is not going to
work in the opposite cases because crowding out will be huge when interest
elasticity of investment is high (flat IS, change in i generates a big drop in I) or
when you have low interest elasticity of Md (steep LM, changes in Md generate
big changes in interest rates).
Topics of importance:
Determination of demand, determination of output in SR, MR, and LR, goods
and money markets (IS-LM), determination of supply, self correction, price
expectations, determination of inflation, rational expectations, IS-LM slopes,
rules vs. discretion.